CHAPTER 6

1
Production Theory
1. Describe short run production
2.Define the Law of diminishing
returns
3.Differentiate stages of
productions

2
 Definition of Production

Inputs processed Outputs

-Land Goods
-Labour &
-Capital services
Production: the
-Entrepreneur process by using the
FOP to produce
goods & services

Ex: to produce paper (output), tree (input) is

needed 3
 Classification of Factors of
Production/Inputs
Conventional perspective Islamic perspective

Land- refer to natural resources such as forest, water,
timber, air and others
(the reward is Rent)
Labor- all forms of human input both physical and
mental in the production
(the reward is Wage)
Capital-Human made resources which are used in the
production process to produce other goods & services, eg:
factory, equipments, tools, machine & others
(the reward is interest)
Land- Nature is a gift from Allah, human should take care
of the environment without damaging it.
Labor- responsible to find ‘halal’ income, practice good
work ethics.
- Social obligation: paying ‘zakat’ and contribute to ‘amal
jariah’
Capital- Should come from ‘halal’ sources, no elements of
‘riba’ (prohibited)

Entrepreneur-Human ability and capability to combine Entrepreneur- Production of goods & services should
land, labour & capital to develop production of goods & follow the Islamic rules, responsible for worker’s welfare
services
(the reward is profit)

4

Firm –
an organization will produce goods or services and supply it to the
consumer.
 Industry – a group of firm that produce similar products in a market
Two Types of Factor Inputs
 Fixed Input
 An input which the quantity does not change according to the
amount of output.
 Example: Machinery, land, buildings, tools, equipments, etc.
 Variable Input
 An input which the quantity changes according to the amount
of output.
 Example: Raw materials, electricity, fuel, transportation,

communication, etc.

Short Run and Long Run Period

 Short run period is the time frame, which at least one of the inputs is fixed
and other inputs can be varied.
 Long run period is the time frame which all inputs are variable.
5
 TOTAL PRODUCT (TP)
The amount of output produced
when a given amount of that input is
used along with fixed inputs.
TP = Qty = Output

TP = AP X L

AVERAGE PRODUCT (AP)

The average production for each input
Divide the total product by the amount of that input
used in the production

Average Product (AP L) = Total Product

Total Labour
AP L = TP/ L

6
 Marginal Product (MP)
* change in total product of that input
corresponding to an-addition unit change in
its labor assuming other factors that is
capital fixed.
Marginal Product (MP) = change in total product
change n total labor

MP = ∆TP = TP1 – TP0

∆L L 1 – L0

7
LAW OF DIMINISHING MARGINAL RETURNS
(LDMR)
 “Law of diminishing marginal returns states
that as more of a variable input is used while
other input and technology are fixed, the
marginal product of the variable input will
eventually decline”.
*******LDMR happen when MP starts to reduced.

8
 Production Function
With One Variable Input

Total Product TP = Q = f(L)

TP
Average Product APL =
L
Marginal Product TP
MPL =
L

9
 MP = TP1-TP0
L1 – L 0 AP = TP
L

Capital Labour Total Marginal Average Stages of

(Fixed (Variable Product Product Product Production
input) input)
10 0 0 - -
10 1 8
10 2 20 STAGE I
10 3 33
10 4 44
10 5 50
10 6 54
STAGE II
10 7 56
10 8 56
10 9 54
STAGE III
10 10 50

SHORT RUN PRODUCTION FUNCTION

(cont.)
10
 MP = TP1-TP0
L1 – L 0 AP = TP
L

Capital Labour Total Marginal Average Stages of

(Fixed (Variable Product Product Product Production
input) input)
10 0 0 - -
10 1 8 8 8
10 2 20 12 10 STAGE I
10 3 33 13 11
10 4 44 11 11
10 5 50 6 10
10 6 54 4 9
STAGE II
10 7 56 2 8
10 8 56 0 7
10 9 54 -2 6
STAGE III
10 10 50 -4 5

SHORT RUN PRODUCTION FUNCTION

(cont.)
11
 SHORT RUN PRODUCTION FUNCTION
(cont.)
RELATIONSHIP BETWEEN TP AND MP
RELATIONSHIP BETWEEN AP AND MP
When MP is increasing, TP increase at an increasing rate.
When MP is above AP , AP is increasing
When MP is decreasing, TP increase at a decreasing rate.
When MP is below AP, AP is decreasing.
When MP is zero, TP at its maximum.
When MP equals to AP, AP is at maximum.
When MP is negative, TP declines.

• 60 • TP MAX
C
• STAGE I • STAGE II * • STAGE III
• 50

• 40

• 30 • TP
• AP =MP
• MP
• 20 • AP MAX;
A* B • AP
* • MP=0
• 10

• 0
• 1 • 2 • 3 • 4 • 5 • 6 • 7 • 8 • 9 • 10
• -10

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STAGE I
Stages of Production
•Starting from the origin (labor = 0) until the
intersection of MP and AP (point B)
•MP rises and reaches the maximum (point
A) (TP is increasing at an increasing rate)
•MP declines (TP is increasing at a
decreasing rate) C
Product
•AP is increasing but below MP
•A rational producer will continue
production
I
STAGE II II
•Starting from the intersection of MP and
III
AP (point B) until TP is maximum (point C /
MP=0)
•MP decreases but still positive
TP
•AP is falling but above MP A
•The most efficient stage (reach maximum B
TP) because utilization of land and labor is
most efficient AP
Labor
STAGE III
•Starting from TP is maximum (MP=0)
MP
•TP decreases
•MP is falling and negative
•Inefficient stage
13
Cost Theory
1.Explain the concept of short
run cost
2.Discuss Long run average
costs
1.Economies of scale

2.Diseconomies of scale

14
CONCEPTS IN COST THEORY
An expenses incurred by firm due to the
utilization of economic resources in production
activities.
as price for input.
Explicit cost – Accounting cost or costs that would appear
as costs in an accounting statement.
Implicit cost – other costs, such as the cost of the owner’s
capital and labor, and/or the cost of alternative uses of each
input.
- short run cost (fixed + variable
factors)
- long run cost (all inputs can be varied)

15
 Fixed Cost (TFC)
 Variable Cost (TVC)
 Total Cost (TC)
 Average Cost (ATC @ AC)
 Marginal Cost (MC)
 Average fixed Cost (AFC)
 Average Variable Cost (AVC)

16
Costs that independent of
output.
 Remain constant throughout the
production
 Must be paid even if output is
zero
 Example: rent, telephone bills,
insurance premium

17
Costs that are;
 zero when output is zero
increase as output increases

Example: cost of labor – wages

cost of raw material

18
The sum of total fixed cost
and total variable cost at
each level of output
TC= TFC + TVC

19
Output TFC TVC TC

0 100 0

1 100 50

2 100 80

3 100 105

4 100 120

20
 SHORT-RUN COST CURVES

TOTAL COST (TC)

COST
TC The sum of cost of all inputs used to produce goods
and services.
Also defined as TFC plus TVC

TVC TC = TVC + TFC

TOTAL VARIABLE COST (TVC)

The cost of inputs that changes with output.

TFC

TOTAL FIXED COST (TFC)

The cost of inputs that is independent of output.

QUANTITY

21
 Fixed cost per unit of output
AFC = TFC / Q

 The average fixed cost curve slopes downwards

continuously due to the spreading of fixed cost.

22
 Total variable cost per unit of
output.
AVC = TVC / Q

The AVC value will decrease in the

first stage, reaches a min and later
increases.

23
Total cost per unit of output

ATC = AFC + AVC

@AC= TC/Q

24
The change in total cost when one unit of
output is produced

 MC = TC/Q = TVC/Q

In deciding how many units to produce, the most

important variable is marginal cost.

25
Q TC AC AVC AFC MC
0 50
1 100
2 130
3 155
4 170
5 190
6 220

26
Q TC AC AVC AFC MC
0 50 - - - -
1 100 100 50 50 50
2 130 65 40 25 30
3 155 51.67 35 16.67 25
4 170 42.5 30 12.5 15
5 190 38 28 10 20
6 220 36.67 28.33 8.33 30

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 SHORT-RUN COST CURVES (cont.)

MARGINAL COST (MC)

Change in total cost that results from a change in output
MC = TC

 
COST Q

MC ATC
AVERAGE TOTAL COST (ATC)
Total cost per output
ATC = TC ATC = AFC + AVC
Q

AVC
AVERAGE VARIABLE COST (AVC)
Total variable cost (TVC) divided by total output
AVC = TVC
Q

AVERAGE FIXED COST (AFC)

Total fixed cost (TFC) divided by total output

AFC = TFC
Q

AFC
QUANTITY

28
When MC < AC, AC falls
When MC > AC, AC rises
If MC = AC, AC at minimum
(MC cuts AC at minimum AC)

29
EXHIBIT 5 SHORT-RUN COST FORMULAS

30
STAGE 1 STAGE 2 STAGE 3

TP/MP/AP

TP

AP

MP units of variable factor (labor)

Cost AVC
MC

Points where the minimum

AVC correspondence to
Point of maximum AP

Output

31
 EXERCISE

The table below refers to short run production of

Campus Bookstore
Based on the table, answer the
Workers Total Average Marginal following questions:
(units) Product (TP) Product Product
(AP) (MP) a) Complete the columns for AP
0 0 - - & MP (4m)
1 10 10 10 b) Which worker has the highest
2 24 12 14 MP? (1m)
3 40 13.3 16
c) How many workers are
4 58 14.5 18 employed when diminishing
5 73 14.6 15 returns to labour set in. (1m)
6 83 13.8 10
d) State the law of diminishing
7 87 12.4 4 marginal product (2m)
8 89 11.25 2
e) Sketch a diagram to show the
9 90 10 1
relationship between AP &
10 90 9 0 MP. (2m) 32
 33

33
EXHIBIT 8

34
35
 Scale of Production

Law of Returns to Scale

 Refers to the effects of changes in the scale
of production.
The responsiveness of output to a given
proportionate change in quantities of all
inputs called returns to scale.
There are three types of returns to scale:
Increasing returns to scale, decreasing
returns to scale and constant returns to scale.

36
 Increasing Returns To Scale
Increasing returns to scale happens when
all the factors of production are increased in a
given proportion, output will increase by a
greater proportion.

Ex: When L and K are both doubled from

100 units to 200 units, output increases from
20 units to 50 units, which is more than
double. This show an increase in the amount
of L and K by 100% bring about increase of
150% (more than 50%) in the amount of
output.

 The causes of increasing returns to scale

could be because of specialization, technical
economies and managerial economies which
are also known as economies of scale.

37
Decreasing Returns To Scale
Decreasing returns to scale happens when
all the factors of production are increased in a
given proportion, output would increase by a
smaller proportion.

Ex: When L and K are both doubled from

100 units to 200 units, output increases from
20 units to 30 units, which is less than
double. An increase in the amount of L and K
by 100% bring about only an increase of
50% in the amount of output.

 The causes of decreasing returns to scale

could be because of competition,
mismanagement, and other internal and
external diseconomies of scale.

38
 Constant Returns To Scale
 Constant returns to scale happens when all
the factors of production are increased in a
given proportion, output will increase by the
same proportion.

Ex: When L and K are both doubled from

100 units to 200 units, output increases from
20 units to 40 units. An increase in the
amount of L and K by 100% bring about
increase of 100% in the amount of output.

39
 Show the r/ship between output & long run
cost
 Refer to the advantages & benefits of firm
enjoys as it becomes larger (expand its
production) since the long run average cost
(LRAC) falls.
 2 types:
 Internaleconomies of scale
 External economies of scale

40
 Internal economies of scale
 Benefits enjoyed by the firm itself
 Occurs as a result of a firms internal decision to increase the
scale of its operation

 Division of labor specialization

 Leads to an increase in efficiency  brings higher output thus results
in increasing returns to scale

 Financial economies
 Large firms obtain loans more easily (interest charged also lower)
 Can also sells shares to obtain more capital to expand firms
 results in lower LRAC as output expand

 Managerial economies
 Administrative economies such as the employment of professionals
like economists or accountants
41
 External economies of scale
 Benefits enjoyed by the entire industry
 Caused by the factors external to the firms itself, relating to the
scale of the industry or market as a whole

 Economies of concentration
 Grouping of firms together within 1 industrial zone can reduce
cost since it is cheaper + easier for government to supply
necessary facilities

 Infrastructure
 Facilities available to the industry to ensure smooth operation
of the whole industry
 Eg: road, ports, railways, water supply, telecommunication,
etc
 enable firms to save cost & production be more efficient

 Economies of information
 Exposed to new information  important to improve quality of
the existing product
42
 Disadvantages/ problems a firm will face it
becomes too large because increases in
output causes a firm’s LRAC curve to rise and
reduces efficiency
 2 types:
 Internaldiseconomies of scale
 External diseconomies of scale

43
 Internal diseconomies of scale
 Disadvantages faced by the firm when it become too big

 Bureaucratic organization
 Lead to slow process of decision making  costly to firms

 Low productivity
 Division of labor may lead to alienated & demoralize of
workers when the organization gets bigger

 Higher wages of professionals

 Increase the cost of production

44
 External diseconomies of scale
 Disadvantages that result from the expansion of the entire
industry

 Social cost
 Taxes will be imposed by the govt because the problem of
pollution or traffic congestion

 Wage differential in the industry

 Eg: AB company pays RM20 per day while CD company pay
RM25 per day to their labors  prevent worker from leaving
the firms + attract new labors, AB company has to pay RM26
or more per day  production cost for both firms will
increase

 Increase in cost of production & fall in returns

 With stiff competition, whole industry will suffer because
their competition in terms of buying & selling  increase in
cost of production

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 Conventional view
 Producer’s objective is to attain maximum profit 
make economics decisions

• Islamic view
 Strive hard in order to get the blessings from Allah
SWT + harmony society
 Maximize profit without sacrificing the blessings from
Allah SWT according to Al Quran & Sunnah

46
47
 TOTAL REVENUE (TR)
The total amount received from the sale of a firm’s goods and services
Total Revenue (TR) = Price (P) x Quantity (Q)

AVERAGE REVENUE (AR)

Average revenue is the total revenue per unit output sold.
Average revenue (AR) is also equal to the price (P) of the good.



Average Revenue (AR) = Total Revenue (TR)

Quantity (Q)
AR = PxQ = PRICE
Q

48
 MARGINAL REVENUE (MR)
The change in total revenue resulting from one unit increase in quantity sold

Marginal Revenue (MR) = Change in Total Revenue

Change in Quantity

MR = TR/ Q





49
50
 Market Structure
Perfect Market (Price constant)-
P=AR=MR=D
- Perfect/pure competition

Imperfect market (Price is not constant)-

P=AR=D (MR<AR)
- Monopoly
- Monopolistic competition
- Oligopoly

51
 Case I: Under Perfect Market
Quantity Price Total Average Marginal Revenue
Revenue Revenue (MR)
(TR) (AR)

1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10 AR, MR and price are same when
the price is constant. The graph
Shows the horizontal line at price
of RM10 which indicates that
MR = AR = Price.

Quantity
Price
15
AP, MP

10
5 AR=MR=DD
0
10 20 30 40 50

52
Case II: Under Imperfect Market
Quantity Price Total Average Marginal Revenue
Revenue (TR) Revenue (MR)
(AR)
1 10 10 10 10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2 AR equal to but MR is less than
price when price changes.
The graph shows the AR and MR
downward sloping and MR curve
lies below AR curve.

Price
15
AP, MP

10
AR=DD
5
MR Quantity
0
10 20 30 40 50

53